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Exploration and Production of Oil and Gas in Kurdistan

2 August 2010

Mayer Brown Article

Iraq is estimated to have one of the largest oil and gas potentials in the world. The country already has proven reserves of 115 billion barrels of crude oil and 112 trillion cubic feet of natural gas. The vast majority of Iraq’s oil and gas fields, however, remain undeveloped, undercapitalized and underexplored, mainly due to the country’s historical political structure and regional conflicts. Iraq has discovered 73 oil fields, including 6-9 “super-giant” fields (producing more than 5 billion barrels each) and 22-23 “giant” fields (producing more than 1 billion barrels per field). Only 15 to 20 of these fields are currently in production.

The Kurdistan Region of Iraq is located in northern Iraq, bordering Syria, Turkey and Iran. Like Iraq, Kurdistan’s economy is highly dependent on the production and sale of oil. It is estimated by the US Geological Survey that there are approximately 40 billion barrels of oil and 60 trillion cubic feet of gas in Kurdistan, giving the region the potential to be a significant new global energy player. Although autonomous since 1991, it was not until 2004 that Kurdistan’s status was officially recognized by the Transitional Administrative Law and reaffirmed by Article 117 of the Constitution of Iraq (the “Constitution”), approved by the Iraqi people in a referendum on 15 October 2005.

In addition to recognising Kurdistan, the Constitution also recognises decisions and contracts issued or entered into by the Kurdistan Regional Government (KRG) since 1992. The grandfathering provision in Article 141 of the Constitution states that: “Legislation enacted in the region of Kurdistan since 1992 shall remain in force, and decisions issued by the government of the region of Kurdistan, including court decisions and contracts shall be considered valid unless they are amended or annulled pursuant to the laws of the region of Kurdistan by the competent entity in the region, provided that they do not contradict the Constitution.”

Since 2007, the KRG has been using a model production sharing contract (PSC) for all participants in Kurdistan, based on a model considered reasonable and in line with international practice. Under the PSC, the contracting company has to comply with an initial three-year exploration sub-phase (seismic plus 1-3 well commitment), following which a second exploration sub-phase of two years can be commenced, with a possible extension granted for further evaluation. Upon discovery, the contractor can apply to enter the development phase, which lasts 25 years (with potential extensions). The contractor has the typical rights and obligations, including (i) recovery of costs; (ii) payment of royalties to the KRG; (iii) sharing of “profit oil”; (iv) bonus payments; and (v) taxes, which are paid from the KRG’s share of profit oil.

In light of its high oil and gas potential, its recognition under the Constitution, its attractive model PSC and the fact that it has proven to be relatively stable and secure compared to the remainder of Iraq, Kurdistan has emerged as an attractive region for foreign investment. In 2006, the first new oil well since the invasion of Iraq was drilled in Kurdistan by DNO, and approximately 38 international companies have now been awarded PSCs in Kurdistan. These include Heritage Oil plc, Gulf Keystone Petroleum Ltd., Talisman Energy Inc., Sterling Energy plc, Korean National Oil Corporation, the OMV Group, Sinopec International Petroleum Exploration and Production Corp. and Reliance Industries Limited. However, the lack of a federal Oil and Gas Law has prevented the establishment of a payment mechanism for oil exports from Kurdistan, leaving two major fields (Tawke and Taq Taq) limited to only domestic sales and placing added uncertainty around needed development of key export infrastructure, which has been problematic for investors.

In addition to the difficulty in exporting production, and notwithstanding the constitutional footing enjoyed by Kurdistan within the federal system of Iraq, the international companies active in the Kurdistan oil sector are subjected to ongoing uncertainty with respect to the validity of the PSCs entered into between them and the KRG. The KRG enacted its own Oil and Gas Law in August 2007 that established the directives by which the region would administer oil and gas operations, consistent with the provisions of the Constitution. The model PSC follows these directives. However the Iraq Ministry of Oil has publicly stated on several occasions that the oil agreements entered into with the KRG after the Kurdistan Region Oil and Gas Law came into force are “illegal and illegitimate.”

Does the Iraqi federal government have justification for calling into question the validity of Kurdistan’s PSCs? Article 112 of the Constitution provides that oil exploration and production is not within the exclusive powers of the federal government, but the federal government of Iraq has a right to “undertake the management of oil and gas extracted from present fields.” Thus, the KRG is not allowed to unilaterally take over management of present fields, even though the federal government may work with the regional governments with respect to these present fields, provided that such arrangements are compliant with the Constitution.

In addition, the Constitution establishes that the federal government must distribute the revenues generated by the extraction of oil and gas from present fields in a fair manner in proportion to the population distribution in all parts of the country. Again, this requirement limits the powers of the federal government to present fields.

These references to “present fields” and to “extracted” oil and gas have led most commentators to conclude that the federal government has no express right under the Constitution to manage non-producing or future fields, including exploratory fields. The Constitution states, however, that the regional governments must always respect the Constitution and any “strategic policies” to be formulated by the federal government together with the regions. Since there are no strategic policy agreements between the KRG and the Iraqi federal government, the regulation of matters relating to future and non-producing oil and gas fields in Kurdistan is directly attributed to the KRG. In addition, the Constitution states that in the case of a conflict between the federal and regional laws, regional law will prevail in the region, provided that it is not contrary to the Constitution. Significantly, there were no producing fields in Kurdistan at the time when the Constitution was approved and came into force (2005), ensuring that all current and future fields are outside the scope of Article 112.

In January 2008, the KRG obtained a legal opinion from Professor James Crawford, Whewell Professor of International Law, Cambridge University. The legal opinion concluded that, on the basis of the considerations referred to above:

The KRG is a recognised regional government under the Constitution.

The Iraqi federal government does not have exclusive authority over oil and gas.

Under the grandfathering provision in the Constitution, all acts, decisions and contracts issued or entered into by the KRG since 1992 shall be considered valid and enforceable provided they do not contradict the Constitution.

The KRG has powers to manage the oil and gas fields not producing, developed or discovered before the date of the Constitution.

Pending agreement with the federal authorities on strategic policies, the authority of the KRG to approve the conclusion and implementation of oil and gas development contracts is unqualified.

Despite this opinion, commercial reality demands that the Iraqi federal government observe and recognise the validity of Kurdistan’s PSCs, since federal cooperation and assistance is required to ensure the proper exportation, marketing and other downstream activities in respect to production from Kurdistan. Since 2007, the KRG and the federal government have been discussing the enactment of a federal oil and gas law to set out, among other things, the framework for payment of crude oil export revenues to the KRG and for marketing of crude oil. It will also reaffirm the legitimacy of oil and gas contracts signed.

This law will be vital to oil companies seeking to invest in Kurdistan because it will remove a number of the current concerns. But it may also represent a limitation to the KRG’s management over the fields, since any new federal-approved law is likely to impose a number of revisions to the model currently in force in Kurdistan, including changes to the regime for royalties and corporate income tax. Until this new law is enacted, however, and despite the legal arguments in favour of the validity of the PSCs, the uncertainty regarding the exploitation of the region’s oil and gas reserves looks set to continue.

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